Knights of the round table: mapping out the markets (June 2007)

In the true ancient fashion of King Arthur’s Knights of the Round Table, we have also gathered men of the highest order, not of chivalry but of investment expertise, at our virtual Round Table. In a world first, and a coup of note, four of the investment industry’s leading lights have gathered to debate and map out the direction of global financial markets.

The investment warriors occupying a special place at our Round Table are:

Knight Martin Barnes, managing editor of BCA Research,one of the world’s leading independent providers of global investment research. Martin was raised in Scotland, but relocated to Canada in 1987.

Knight David Fuller, a career analyst, writer, lecturer and investor/trader. He is a director of Stockcube Research where he is Global Strategist and the producer of the daily Fullermoney investment commentary. David was born in New York, but has been living in London since 1969.

Knight John Mauldin, president of Millennium Wave Investments and the author of the Thoughts from the Frontline e-letter and two New York Times best-selling books, namely Bull’s Eye Investing and Just One Thing. John lives in Dallas, Texas.

I have assumed the King’s role in this cast, or more specifically that of moderator of the discussion.

The scene has been set, the wine has been poured and our warriors are ready to do battle.

Prieur: Gentlemen, let’s commence our discussion with a bird’s-eye view of economic growth. Firstly, where are we in the US economic cycle? Martin would you like to set the ball rolling?

Martin: Certainly. The economy is only part-way through a long expansion that began in 2001, after the briefest and mildest recession on record. The economy has been growing below trend since the second quarter of 2006, and this seems likely to persist through the end of this year, reflecting ongoing woes in housing and some retraction in consumer spending. There are no indications of recession any time soon.

David: The US economic cycle is going through a predictable slowdown, largely because of the sub-prime problems, exacerbated by rising long-term interest rates. I maintain that this is no more than a mid-term lull, not least due to the overall strength of the global economy, led by Asia.

The next slowdown period for the US may be in 2009 and 2010, if the Fed and a new administration in the White House decide to clean the Augean stables during the first two years of the US presidential cycle, as is sometimes the case. Also, money-supply figures indicate that inflationary pressures will increase, albeit erratically.

Barry: Based on historical comparisons, we are somewhat late in the cycle. But I hasten to add that prior cycles have not seen this much liquidity in terms of ultra-low rates and printed money. So it makes it difficult comparing apples with apples.

It’s also worth noting that we are only four years from the post-crash bottom. The effects of that collapse are still being felt.

The significance of the housing boom to the US economic expansion from 2001 to 2006 cannot be overstated. The full fallout from that unwinding, in both the sub-prime bust and the impact on consumer spending, is yet to be seen.

John: It seems that the discussion is progressing from relatively upbeat to my rather bearish stance. I still think we will see more of the current slowdown and perhaps a recession, primarily due to the slowdown in housing. As an example of the problem, the Los Angeles Times reports that the most recent UCLA Anderson Forecast for California suggests that the housing market there may not return to “normal” until mid-2009, and job losses in real estate finance and housing will depress hiring through the middle of 2008, lifting the unemployment rate in the Golden State to 5.5%. That certainly corresponds to at least a mild localized California recession. And I think that scenario will play out to a greater or lesser degree throughout the country.

That said, the rest of the economy is doing well, so I think that we will see a continued slowdown or mild recession for this year and then, coming out of that, the US economy should start doing well again.

Prieur: The panel’s views seem to range from a mild slowdown to a mild recession. In order to focus on specifics, can you name one or two key drivers of the US economic outlook and how you see these factors playing out?

Barry: Rates, Rates, Rates. That’s been the driver of so much activity, from housing to consumer spending to the carry trade to the sub-prime debacle. It comes back to ultra-low rates as the source of much of the global liquidity, from the carry trade to the leverage of hedge funds to making the relentless private equity bids feasible. Once rates tick up over 6%, the wave of liquidity the bulls have been surfing will dry up. That could have quite significant repercussions.

Martin: Recent volatility has been related to housing and inventories, and these should become less important going forward. Consumer spending has shown remarkable vigor in the face of the housing and energy shocks, but the case for some slowdown in spending growth is now very compelling. However, as long as the labor market holds up, then it should be a moderate retrenchment, not a collapse.

John: I have been writing about this often, but remain of the view that the key driver of the US economic outlook is the housing market. Not only is it hurting on the employment front, but it is also hurting mortgage equity withdrawals (MEWs), which is slowing down consumer spending as borrowers can no longer use a 15% annual increase in their home values as an ATM.

David: The US is undergoing a difficult cyclical adjustment, due to prior excesses, a lack of budgetary discipline by the government and competitive pressures exacerbated by globalization. However, globalization is far more of a long-term opportunity than a liability, particularly for America’s multinational companies. Innovation remains a great strength of the US economy.

Barry: Thinking of it, I am also concerned about the backlash to US policy: it’s no coincidence that the US dollar is at a five-year low at the same time US popularity in the world is also at a low ebb.

Martin: Barry, keep in mind that a positive aspect of dollar weakness, coupled with a strong global economy, is that net exports will become a more important source of growth going forward. Underlying growth seems likely to remain close to 2% in the second half of the year and maybe a bit faster next year.

Prieur: How do you see the rest of the global economy, with particular reference to hot spots such as China and some emerging markets?

Barry: The interesting thing is that for the first time in a century the US is not the locomotive of global growth – we are the caboose, bringing up the rear. That is an unusual turn of events to say the least.

Martin: The global economy has proved to be very resilient. During the past several years, fears that growth would be undermined by high oil prices, financial imbalances, a Chinese hard landing and, more recently, the US housing downturn, have proved misplaced.

There are still lots of risks in the outlook, but the policy environment remains benign and growth is becoming better balanced, with less dependence on the US consumer. The emerging world in general and China in particular will continue to grow strongly. I see no reason to expect any major slowdown in growth, barring some unforeseen shock.

David: The big change is that we have evolved rapidly from a unipolar to a multipolar world. This was inevitable and the prior imbalance existed only because Asia’s large-population countries were previously unable to get their capitalist acts together. Asia’s smaller countries, long led by Singapore, demonstrated the path to prosperity and Deng Xiaoping ignited China’s boom with his pronouncement: “To get rich is glorious”. China, India and probably Vietnam will continue to lead Asia’s strong economic growth and the region, with its large population, is now the primary engine of global GDP growth.

John: I share David’s views and am more optimistic about world economic growth, particularly most emerging markets and China. The concern is that China could become overheated. I think the Chinese government is going to let the renminbi rise at a faster pace in the coming years as part of an effort to slow down its economy and especially speculation.

Barry: Yes John, the bad news is that many markets have gotten speculative and frothy. But the good news is there are lots of opportunities around the globe.

I hate to lapse into a cliché, but I suspect individual stock picking – as well as regional and sector selection – will become increasingly important in this environment. Buying the S&P 500 Index and forgetting about it may not be the highest return approach over the next few years.

Prieur: The panel’s view therefore is that any slack left in the global economy by the US would be taken up by other parts of the world. What does all this mean for interest rates, and more importantly real interest rates, as inflation concerns seem to have moved to centre stage?

Martin: Strong global growth has pushed real bond yields higher, but they remain below their historical averages, reflecting continued surplus savings in emerging Asia and among oil producers. Over time, real yields will revert to more normal levels, but it should be a gradual process.

The inflation outlook is benign, reflecting the positive supply-side forces of globalization, technology and market reforms in many countries. As a matter of fact, inflation is more likely to surprise on the downside than upside in the coming year. There will therefore not be any need for central banks in the major economies to impose a monetary squeeze.

In sum, the upside in short- and long-term interest rates from current levels is limited in most countries. One notable exception is Japan, but the process of policy normalization will have to await a much stronger economy.

John: I am less bullish than Martin on inflation and think that it is not completely under control and, until it is, the Fed risks its credibility if it cuts rates. I therefore think the Fed is on hold for longer than most observers are forecasting, which is what I have been saying for a long time. The earliest the Fed will cut rates is in the fall, and maybe not even then.

Barry: The most important issue to my mind is which of the competing demands will force the Fed to pay more attention to it: the weakening US economy, or the ongoing increase in inflation. Unless the US economy re-accelerates in the second half of 2007, the Fed may shift from inflation hawk to recession watch. And given what chief financial officers have been saying in terms of capital expenditure and hiring, it is hard to see anything other than a modest uptick in GDP in the second half at best.

John: Interestingly, the Chinese and other central banks have actually started selling some of their US government bonds. The Chinese sold about $5 billion in April and are likely to continue that process. So, not only are they not buying more, they are also selling, which is going to put pressure on bonds as the rest of the world will probably want to rebalance their portfolios as well. US long-term interest rates may therefore rise more from here.

David: This ties in with my view of long bonds. I maintain that long-term interest rates bottomed in mid-2003, and started a generational-long process of moving higher in a somewhat choppy bear market for government bonds. More often than not, we will have real interest rates relative to the CPI, but everyone knows that this understates inflationary pressures. A synchronized global economic expansion is always somewhat inflationary, and this one will be more so in terms of commodity prices, because so many more people are participating, not least in Asia. The restraints on inflationary pressures will remain competition in manufacturing and international services, plus technological innovation. Nevertheless inflation will rise, erratically, until the next global recession, whenever that occurs.

Prieur: In summary, John and David are bonds bears, Barry is vacillating between inflation and recession and Martin is fairly neutral. Let’s then discuss the bearing of this on the carry trade and global liquidity.

Martin: The carry trade will persist for a while longer. Once it is clear that Japanese interest rates are on a steady uptrend, the carry trade could unwind viciously because the yen is massively oversold and has huge potential for a reversal. The key question is, of course, when this will happen. The economy really is disappointingly weak given the stimulative backdrop of near-zero interest rates and a record-cheap yen. While the recent GDP data have been strong, they are of dubious reliability: if the Bank of Japan really believed the GDP data, it would have raised rates by now.

An unwinding of the yen carry trade would remove some liquidity from global markets, but it is far from the whole story. A benign economic environment of decent growth and low inflation encourages strong demand and supply of credit and we have a financial system that creates all kinds of innovative ways to create even more leverage. The liquidity glut is more about that than simply the yen carry trade. As long as inflation is tame and interest rates are close to neutral, credit-based liquidity will remain plentiful.

David: In my view the yen carry trade will continue until the Japanese government and Bank of Japan both agree that it is no longer in their national interest. Meanwhile, a generation of Japanese policy makers, scarred by the “Endaka” (strong yen) experience, is determined not to let it happen again. Countries that do not want to see their currencies soar will have to cut short-term interest rates and print more money. This will help to keep global liquidity abundant, more often than not.

John: Keep in mind that one of the most important drivers of the carry trade is Japanese consumers, who are borrowing large amounts to buy higher-yielding bonds elsewhere, emulating risk-tolerant hedge funds around the world. This means a lot of exposure is in relatively weak hands, and could make for a very volatile market.

Barry: I view this very simplistically: as rates move higher, the carry trade will ultimately have to unwind. Slowly at first – expect to hear the words “measured” and “controlled” a lot from many pundits. Then, if the exact wrong conditions come together, it will accelerate – dramatically. There will be some leveraged fund blow-ups that will make the recent Bear Stearns sub-prime hedge fund mess look like a Saturday romp in the park.

Prieur: How does this impact the US dollar and what should the currency exposure of a global portfolio look like?

Barry: The US dollar as the world’s reserve currency looks to be potentially in trouble.

I am greatly concerned about the perception of the US on the global stage. The past few years have taken the concept of the ugly American to new heights. And several nations – in the Middle East, Europe and Asia – would just love to drop the dollar in favor of the euro. That has potentially disastrous consequences for a debt-laden nation.

I am not particularly comforted by the strategy that restates JP Getty’s quote: “If you owe the bank $100 that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.” What happens when you owe the bank several trillion dollar?

David: I agree that the US dollar remains a fundamentally weak currency. However, its downside is cushioned somewhat by short-term interest rates and reluctance among all countries to see their currencies appreciate rapidly in today’s competitive economic environment created by globalization. My preferred forex exposure is to overweight Asian currencies, the yen excluded.

Resources currencies will also remain firm, at least while commodity prices continue to show an overall upward bias.

Martin: I share David’s view that the US dollar has more downside against the emerging Asian currencies. The renminbi peg is outliving its usefulness for China and it will soon be allowed more of an appreciation. That should drag up other Asian currencies and might even be the trigger for a rebound in the yen. I do not see much more downside for the US dollar versus the euro.

Fears that China and/or other countries will precipitate a dollar crisis by diversifying into other currencies seem misplaced. Nobody has an incentive to create a dollar crisis that could weaken US growth. Asia would be the big loser from this and the damage could far outweigh the threat of losses on its dollar reserves.

John: I guess it is four in a row as I also favor the Asian currencies first, then the euro (at least for the next few years), as well as the “commodity” currencies like the Canadian dollar and Australian dollar.

I think that more and more investors must seek to be global investors. There is no hard and fast rule for what your foreign exposure should be, but if you can stand the volatility and have access to world-class managers who can do stock selection with some hedges rolled in, then 25% to 40% of a portfolio might be appropriate for more aggressive investors. However, your exact currency exposure depends in a big way on your home country and where you plan on spending your assets in retirement.

Prieur: That makes it a full house of dollar bears. Does this indicate that there is a role for gold in an investment portfolio?

David: Yes, because we live in a fiat-currency world. Consequently gold should appreciate against all paper money over the long term. However, on a daily basis gold is subject to the ebb and flow of investment fashion trends, just like everything else.

Barry: If you expect inflation to remain pernicious as I do, gold certainly has a place. The story of the past five years is one of investors swapping dollars for hard assets: gold, oil, agricultural products, real estate, office buildings, etc. Cash has, unfortunately, become trash. That argues for increased commodity exposure in individual portfolios.

Martin: I should state that I am not a gold bug. And because I am optimistic on inflation I don’t see the need to buy gold as an inflation hedge. However, I can see that an environment of rising global prosperity and buoyant liquidity creates a favorable backdrop for gold.

The problem is that I don’t know how to value an asset that does not produce an income stream. What is the right price for gold – is it $700, $1 000 or $1 500? If the case for buying gold is that other people will be buying it so I’d better get on board, then it is a greater-fool-theory argument and I am not comfortable with that. I can see the case for owning some gold, but perhaps no more than 5% of a portfolio.

John: I also think everyone ought to own some insurance gold. However, as far as investment gold is concerned, I think there are more interesting plays than gold. If you have the time and ability to understand the resources markets, there are some excellent opportunities. But this is one asset class where homework pays off.

Barry: Here’s a free idea for Barclays’ ETF factory: how about an ETF that covers some of the major commodity indices? Not just individual metals or oil, but the full basket? That would be a billion-dollar seller.

Prieur: Gentlemen, you have described the big picture backdrop very eloquently. Let’s now focus on the outlook for the major asset classes. Firstly, equities – why do I suspect you are more bullish than the rest, Martin?

Martin: I believe equities will grind their way higher against a backdrop of reasonable valuations, continued earnings growth, decent liquidity and an ongoing M&A/private equity boom. Emerging markets should outperform, whereas the US and euro-area markets should perform broadly the same. Japan, however, is a big question mark – it holds the promise of outperforming, but has consistently failed to deliver. Global stocks will outperform bonds and cash.

Barry: As long as profits stay high, equities will do fine. That’s dependent upon the US consumer remaining resilient – something looking increasingly at risk.

The flip side of that is that our technical models continue to identify attractive stocks based on improving money flow, rising institutional ownership, short interest, and other technical factors – despite the ongoing economic deceleration. Whether the root cause is liquidity or fundamentals, it has kept us in equities far longer than what our instincts would have us do. We have been long, our clients have been making money, and I have been miserable. It just goes to show how worthless our emotions are when it comes to investing.

John: I am rather bearish on US equities and am more interested in emerging-market stocks, but I want to avail myself of them only through experienced managers on the ground in those countries. Investing in emerging markets is tough over long distances. China is clearly in a bubble, although it may go on a long time, as the conditions for a continued increase seem to be in force.

Prieur: That brings us to bonds. David?

David: Bonds are in a secular bear market. Bonds will underperform more often than not, at least until the next bear market for equities is well under way and/or a global recession occurs.

Barry: The 25-year US bond bull market looks to be over. There should be better rates for those looking for income shortly. But it is a race to see which hits first: inflation or recession.

John: I agree rates are still on the rise, so short term I would be invested in shorter durations almost everywhere.

Martin: Bonds are also not on my buy list and there is not much opportunity for sustained capital gains. A world of low and relatively stable inflation is not very exciting for bonds. Meanwhile credit spreads are very tight, so there is not much case for being overweight in non-government bonds either. A relatively boring asset class right now.

Prieur: The commodities markets have been characterized by significant gains over the past few years. Do these markets still have legs?

Barry: Definitely, Prieur. Commodities may just be getting started in a longer-term bull market. One only needs to look at historical commodity cycles to see that they tend to last decades, not years.

David: I am also in the bullish camp as I believe a supercycle bull market is under way, led by industrial metals. However, prices are notoriously volatile, especially agricultural commodities.

John: I am also long-term bullish on oil, copper and other commodities that are tied to rising demand curves in the developing world. Oil is set to rise a lot in the coming decade.

Martin: Long run, the commodity outlook is positive because demand will be strong and relatively high prices will be needed to ensure that the supply materializes. I guess that makes four out of four long-term bulls.

However, base metals are vulnerable to a further correction because spot prices are so far above marginal production costs. At some point there will be a deluge of supply, but it is taking time because of previous under-investment. The oil-price outlook is more positive because of the precarious supply picture.

Prieur: That makes it four out of four long-term commodities bulls. Let’s hope periodic short-term corrections provide us with buying opportunities.

We have discussed the economic implications of the housing situation, but how do you see real estate as an investment class?

Martin: The housing downturn in the US will play out over a couple of years, at least in terms of real prices stabilizing. Commercial real estate offers poor value. Maybe real estate in parts of emerging Asia offers good opportunities, but one would need some good local knowledge to capitalize on that.

David: Real estate provides a hedge against inflation, but it is always a question of location, location, location.

Barry: Except for off the coast of Dubai, they ain’t making more of it. As long as the population keeps rising, real estate remains a long-term hold. As much as I whine about the damage that the boom/bust cycle can do, consider this: that vacation property grandpa bought 40 years ago – imagine he overpaid by 50%. The returns since then still have been fabulous. So while I caution against speculating in real estate, if you fall in love with a unique piece of property you are going to buy and keep in the family for years if not generations, I counsel people to go for it. The risk is it drops 30% over the next 10 years, versus not getting it ever again.

John: All real estate is local. It is hard to make a general statement that makes sense. There is always a deal somewhere.

Prieur: The only asset class remaining is cash. King or trash? David?

David: Neither. This is strictly a temporary bolt-hole choice. Paper money does not retain its purchasing power over the long term.

Martin: Also neither. Cash will not outperform over the next 6 to 12 months.

John: Another vote for neither. Each individual has to manage his own needs. I tend to find opportunities that I think are more attractive than cash.

Barry: Trash. Until the dollar gets deeply oversold, it is to be avoided.

Prieur: What are the biggest risks, in other words wild cards, to any investment scenario? John, is this a topic your forthcoming book, Millennium Wave, will cast some light on?

John: Hopefully. I see the biggest risk as the unknown or black-swan event. The world always hedges against the last problem. I don’t think we will see another Long-term Capital, for instance. Everyone is looking for that and making sure they are covered in that area. I think one real risk is that oil and energy prices may rise a lot more over the coming years than the market is forecasting. And individual companies are subject to a rapid change in technology wiping out their current competitive advantages.

Martin: If John’s concern about higher oil prices materializes, then a definite risk is that my optimism on inflation is misplaced. In that case, central banks will have to inflict pain and we will end up will a typical monetary squeeze that will be bearish for growth and equities.

David: Bubbles – every great uptrend eventually waltzes into a cul-de-sac. Tight monetary conditions are a periodic risk for all appreciating asset classes. And as Harold Macmillan said: “Events, dear boy, events.”

Barry: I believe people are dramatically underestimating the impact of a profit slowdown. That will make stocks suddenly look quite pricey.

Next on the list is a derivatives blow-up. And finally, terrorism going bio-chemical is becoming increasingly easy. Over the next 20 years, the odds of an event with 100 000 casualties are increasing.

Martin: There are obviously lots of risks related to geopolitics and financial accidents, including excessive leverage, but these are impossible to time or quantify.

Prieur: Finally, as a parting comment, what are the most important lessons that you have learnt during your investment career?

John: I think that we underestimate the accelerating pace of change we are going to see in the next 15 to 20 years. We will see more technological change in the coming decade than we saw all of last century. Think back just 20 years and realize how much things have changed. Then double that pace through 2020. The opportunities and displacement are going to be huge. Picking the broad waves of change, “themes” if you will, has been a very good way to boost investment returns.

David: Buy low, sell high. Observe the crowd in the manner of a naturalist, because the pendulum swings of sentiment, from manic to depressive, will dictate both short- and medium-term market trends. Keep your ego under control, otherwise it will undermine your perspective.

Barry: Yes, David, isn’t it amazing how human nature works against investors. Our instincts were not honed for the capital markets, and our emotions work against us.

This leads to all sorts of interesting corollaries: the future is inherently unpredictable, yet investors seem to constantly engage in “here’s what I expect to happen” analysis. They would be much better off doing probabilistic rather than predictive investing. Understanding probabilities is very important. This leads to the inevitable conclusion that the process is much more important than any given outcome. Lastly, valuation matters much more than a good story, and yet, it’s the sizzle that all too often sells stocks and not the steak.

Martin: I concur with Barry. There are so many forces and imponderables that affect the outlook, that one must keep a very open mind and not get trapped in a fixed mindset. Too many people have locked themselves into either a bullish or bearish view and that undermines their willingness and ability to take account of a changing environment. It is important never to become overly confident that you have it all figured out.

Prieur: With those words of wisdom we conclude a fascinating discussion. While we have heard differing views on a number of variables, there were also some common threads that should assist in keeping investors on course. Given the success of this inaugural Knights of the Round Table discussion, we would attempt to reconvene towards the end of the year to map out the course for 2008. Thank you Martin, David, John and Barry. May the markets be kind to you.

Thinking of the longer term, could Malthus have the last laugh? That is to say that China has voluntarily limited its birth rate, which is a huge sacrifice, perhaps unparalleled in history: if there is a physical limit to the use of world resources, would they not expect the rest of the world to share the pain? ‘Pain’ means running Western economies below potential, thus reversing the relative attraction of equity and bonds.

If there is no such limit on growth, the real boom-and-bust scenario is that growing prosperity encourages the Chinese and Indian populations to explode at an accelerating standard of living…

Much as I like most of the discussants, there was a little too much agreement for my taste. Then again, it may be more a question of who gets picked… I would have been in agreement on most of those points as well… which should give me more pause.

Not much mention of the derivative explosion in the discusssion… While it is often billed as a booster of markets’ liquidity, isn’t it also dependent on the markets’ liquidity? Seems a bit circular in reasoning. I think we do not have adequate understanding of the significance of the growth of derivatives. I worry a great deal about the liquidity argument often given as support for the bull market. That was the main supporting argument for the Japanese bull market of the early ’90’s

I really enjoyed the discussion, nothing really new but good perspective. I agree with John’s point re underestimating the impact of new and accelerating technology.Communications,Healthcare,Nano?
They can all create a new world!

The thing that worries me most is the situation of the US housing market (and most of the world at that) and the use of MBS and CDO’s as a vehicle for financing the boom. It was not discussed as a concern amongst the panel but I really do see this as a major spanner in the works of much of what they have discussed. The panel in general agree the housing market will be (is) in a protracted downturn, which in theory (Walls street currently in major fire fighting mode to prevent this) should massively devalue these MBS and CDO (as seen recently with Bear Stern) with ever increasing mortgage defaults. Many trillion of dollars have been passed around world in this form of new bond. These have ended up in private investors funds and pension funds with the small guy left carrying the can (not that they know it yet). I can only see this as having a significant impact on the economies that have bought or driven this new form of funding credit. The recent period of unsustainably low interest rates which has driven the financial markets to create these “innovative” products in search of yield will haunt us for a very long time to come.

Very well done. Appreciated the coverage of the various asset markets. The exhortations and admonishments regarding lessons learned and how to view the future are a good review of basics. The suggestion of humility and a re-weighing of my perspective of opportunities and risks is an important lesson in the world we’re in today.